Europe’s New Insurance Solvency Regulations

Vicki Zhang

For nearly 40 years, in spite of differences in many areas, European’s insurance regulation has shared one thing in common with its US counterpart: a minimal amount of harmonization across jurisdictions. The US has the National Association of Insurance Commissioner (NAIC) model insurance regulation, but with a voluntary opt-in system. Most states adopt a version of regulation that is based on the NAIC model law but with unique “state characteristics” which routinely give massive headaches to national insurers who have branches all over the United States. European’s insurance regulator operated in this same non-coercive fashion, codified in the Solvency I directive introduced in the early 1970s. It allowed for variations to emerge in the adoption of the regulation across Europe and led to different regimes. Such a “federalist” approach has been called into question in the recent decade, and in the wake of the global financial crisis a new framework of European insurance regulation, Solvency II, was born.

The new regime will apply to insurance companies in all 27 European Union member states plus three of the European Economic Area countries, with an exemption for certain small companies based on gross premium income (CEA 2007). The birth process of the new regulation has been lengthy and painful at times. Bickering from the industry lobbyists and “turf wars” among national regulators has repeatedly delayed the full implementation of Solvency II. But Solvency II persists, and will go live for supervisors and the European Insurance and Occupational Pensions Authority (EIOPA) on June 30, 2013, finally replacing the Solvency I requirements on January 1, 2014 (European Commission 2012).

The ambition of Solvency II goes beyond the harmonization of regulatory directives across Europe. It also aims to strengthen the capital adequacy requirements, risk management process, and governance in the insurance industry. It is now widely recognized as the most comprehensive insurance regulation regime in the world, and will help reduce insurance related consumer loss and market disruption. A main feature of Solvency II is the market-consistent asset and liability valuation framework, which contrasts the traditional models requiring high levels of arbitrary judgment. Moreover, in setting solvency capital standards, Solvency II promotes the stress testing approach where stochastic processes are simulated based on a large sampling of historical as well as non-historical but probable “shock” scenarios. This is a key lesson learned during the financial crisis: history is important only to a certain extent. A solvency (as well as risk assessment) model has to take into account potential disasters and downturns that have not been observed in the past. Solvency II channels this understanding and builds it into a new standard (EIOPA 2012).

Meanwhile, the insurance regulators outside Europe are slower in upgrading their regimes. The current statutory standard of insurance valuation in the US and Canada, for instance, significantly deviates from the market-consistent economic valuation principles that Solvency II has adopted. Insurers in the US are still using undiscounted reserves for their short-tail product lines to comply with the US NAIC statutory accounting practices. The Canadian framework does not allow for recognition of company-specific experience or diversification benefits across different line of business. For instance, when an insurance company offers both a life insurance and an annuity product, the aggregated insurance risk from the two lines of business should be reduced due to the diversification effect. An insured who suffers a premature death poses a risk to the former product line, while the same insured is considered a “good” risk for the latter. The solvency capital requirements calculated without consideration for diversification are not tailored to the specific risk profile of the insurer.

The uniformity in the calculation of capital requirements can be a source of grave concern for the regulators, as regulatory capital that does not approximate the true underlying risk profile of an insurer can lead to arbitrage opportunities, where an insurer may take on more risk than what has been reflected in the required solvency capital. It will in turn threaten the security of policyholders’ benefits. In fact, a company may stay in business for years, setting aside the amount of required solvency capital without being detected by the regulator as perching on the edge of insolvency. For all the above reasons and many others, national regulators outside Europe are currently monitoring the development of Solvency II and the industry is anticipating the advent of regulatory reform in the years to come. To understand the reasoning behind Solvency II, this article will first offer a bird’s-eye view of the directives and then focus on the requirement to strengthen capital to demonstrate the lessons that can be learned from the European framework.

What is Solvency II?

Pillar I

There are three so-called “pillars” in the directives. Pillar I covers financial requirements and capital adequacy of the firm and how these translate onto balance sheet. This involves three main considerations: (i) assets, (ii) liability, and (iii) capital.

(i) Assets

According to Pillar I, all assets need to be valued on a market-consistent basis. For assets with an established market, such as stocks, options and futures, market value should be used in the valuation. For others that do not have a readily available market, insurer should “mark the asset to model.” This means the valuation result should be based on a model that uses market inputs; in other words, the model is an extrapolation based on the actual market variable such as yield curves and equity index prices.

(ii) Liability

On the liability side, the so-called “exit value” is used. Exit value is the value at which the liabilities “could be transferred, or settled, between knowledgeable willing parties in an arm’s length transaction” (European Commission 2008). There are two considerations in calculating the exit value. Liability cash flows are divided into hedgeable and non-hedgeable components. For the hedgeable portion of the liabilities, it is assumed that there is a liquid financial instrument market for hedging and the values of liabilities being hedged can be determined through the market.

Insurers also usually have non-hedgeable liabilities due to the long-tail and “exotic” nature of their policy liabilities. The non-hedgeable risks in the liability cash flows are trickier to calculate. Solvency II uses the sum of “best-estimate liability” (BEL) and a “cost-of-capital risk margin” (CCM) as the value for this portion of the liabilities. Best-estimate liability is the probability-weighted present value of all future liability cash flows using the risk-free interest rates (i.e. US Treasury bill interest rates). It is considered an estimate because the actuarial assumptions that go into the present value calculation are based on most likely scenarios instead of extraordinary or stress scenarios so there is little conservatism built in for its calculation. The CCM component of the non-hedgeable liability calculation is considered innovative compared to the valuation methods currently being used all over the world. This is where the solvency capital calculation is woven into the liability valuation; traditionally these two calculations are kept separate.

Solvency capital calculated under Solvency II captures the underwriting risks on the existing policies, the counterparty default risk with respect to reinsurance ceded, as well as operational risks. The insurers are required to secure access to these capital amounts in each future valuation until the end of coverage period of the policies insured. Rather than setting aside the entire amount of solvency capital, firms often take out a financial instrument such as a letter of credit to make sure they can access the required capital amount should they need it. In turn, they pay a fixed cost of capital to the issuer of the credit (i.e. a required return on capital or an interest paid to the potential capital provider).

The cost-of-capital risk margin can therefore be considered the present value of all interest paid to secure a letter of credit that gives the firm the access to the full amount of solvency capital in all future periods until the end of the policy. The CCM component of the liability valuation is a major innovation in solving the problem of arbitrariness in the traditional approach of assessing the risks embedded in insurance liabilities. As we will see later, the solvency capital calculation is often based on sophisticated stochastic models with a large pool of scenarios to assess the risks; taking advantage of the results from this process in valuating liabilities would be a far more superior approach than the current formula-based valuations.

(iii) Solvency

Aside from asset and liability valuations, the substance of the Pillar I directives comes from the solvency capital requirements. There are two levels of capital requirements: Minimum Capital Requirement (MCR) and Solvency Capital Requirement (SCR).

MCR is the level of capital required to give the regulator 85% confidence that the assets will be sufficient to cover liabilities over the following 12-month period, and SCR has a similar definition with the confidence level set at 99.5%. SCR implies a solvency capital that would withstand most stress scenarios as long as the scenarios occur once every less than 200 years. Firms whose available capital falls below the SCR will trigger the “ladder of intervention” on the part of the regulator to restore the financial health of the insurer within a set period of time. Firms falling below the MCR will have a shorter period of time to recover their position. On failing that, the insurer’s license will be revoked.

The SCR standard formula is divided into the life and non-life underwriting component which includes premium and claims reserves as well catastrophic provisions to cover the underwriting risks, market, counterparty default and optional risk components. The Solvency II standard formula applies a combination of stress tests, scenarios, and factor-based capital charges to determine the solvency capital for individual risks described above. It then prescribes matrices to aggregate individual risk components by taking into account the correlations between each pair of different risk components.

For instance, if market and credit risks are deemed to be positively correlated (which was the case during the recent financial crisis), a stock market crash is likely to lead to trading counterparties defaulting on their liabilities. In this case, the aggregated solvency capital to cover the risks based on the two sources should not simply be the addition of two individual solvency capital components, but a higher amount based on the correlation between the two risks to reflect the positive feedback mechanism. Conversely, when portfolios are well-diversified to reduce and mitigate risks, the aggregation process will reward such diversification by arriving at a lower solvency capital compared to simple addition of individual capital components.

In addition to the standard formula, Solvency II allows for the use of company internal models. Some firms, in anticipation of regulatory change, have developed sophisticated internal models based on their own specific risk profiles. These models often involve stochastic simulations based on a large number of normal, stress, and catastrophic (“shock”) scenarios. These types of simulations used to be daunting and computationally expensive. Due to new technology developed in fields such as computer engineering, electrical engineering, math and statistics, those calculations can be done in a much cheaper and faster fashion.

Pillars II and III

Pillar II imposes higher standards of risk management and will lead to changes in the way companies carry out their governance of the business. It requires companies to set up or enhance their risk management systems. Their risk management strategy must include details of objectives, risk appetite, and how the firm will assign risk management responsibilities. Risk management policies must define and categorise risk limits by type, detail procedures of implementation on a daily basis, and be well documented.

There should be processes and procedures in place to identify, manage, monitor, and report both current risks and anticipated future risks. There are also rigorous reporting requirements meant to ensure that these processes are being followed.

Firms are required to internally set up the compliance, risk management, auditing, and actuarial functions, each with detailed regulation guidelines. The outsourcing of governance functions is not permitted if the result would impair the quality of internal governance, increase the firm’s operational risks, or reduce the regulator’s ability to monitor the firm’s compliance with Solvency II obligations.

Pillar III further lays out the reporting and transparency requirements. Firms will have to file both a private report to the regulators and a report addressing the public.

Beyond Europe

As Europe makes major headways towards a more market-consistent, transparent, comprehensive solvency standard, the rest of the world remains improbably slow in reacting to the weakness of insurance regulation uncovered during the financial crisis. Even in US, where the insurance giant AIG was bailed out three times by the Federal Reserve after losing 90 percent of its market value and failed to get back on its feet even with the initial bailout, insurance regulation reform has been hard to come by.

Part of the problem is that the International Association of Insurance Supervisors (IAIS), the organization that bears the responsibility of setting global benchmarks and rules has not made substantial contributions to the post-crisis standard building. Without a unifying international authority, insurance regulators of various countries and regions are left to their own devices. National regulators have to address several especially pressing issues to prevent a repeat of the 2008 financial crisis.

For instance, one of the most critical components of insurance company liability is the reserve set aside to cover future claims to be paid out to policyholders. Such liability is difficult to hedge using financial instruments due to its exotic nature; even when a hedging strategy is put into place the protection is almost never perfect. As we have seen above, Solvency II took a big step forward by combining a best-estimate liability based on a stochastic process with large amounts of scenarios and a cost of capital component in the valuation of such non-hedgeable and non-diversifiable risks. The stochastic process keeps the subjectivity of the calculation to a minimum. The cost of capital reflects the market price of these risks and calculates the risk margin explicitly since it is the required capital return on the present value of solvency capital.

In comparison, North American regulators have not given this critical issue the attention it deserves. The US regulation allows an implicit risk margin for such liabilities by using undiscounted cash flows in the reserve calculation that include a built-in conservatism. However, a concern arises since the capital available for solvency purposes (i.e. statutory available capital) is simply assets minus liabilities; under the current regulations, when the prevailing interest rate is higher, even though the “implicit” reserve is higher, the liability on the balance sheet stays the same and so does the statutory available capital. In other words, the implicit reserve is not recognized on the balance sheet as an additional solvency buffer for regulatory capital purposes. The implicit and opaque nature of the US liability valuation makes it difficult to reliably compare the relative solvency strength of different insurers and renders the US solvency balance sheet risk-insensitive.

The Canadian liability valuation margin for insurance claim reserves is an entirely subjective input based on the professional judgements of company actuaries (with a relatively large prescribed range). The available solvency capital is in turn subjective and therefore it is challenging to make meaningful comparisons of solvency strength across companies. Moreover, the expected return on the portfolio investment is also estimated based on actuaries’ personal judgement instead of a more objective and uniform process. The investment return margin depends on the manner in which the investment assets are deployed. This presents opportunities to companies who use “creative” investment strategy to avoid setting aside large amount of solvency capital. In fact, by taking on riskier investments, the company may derive higher expected portfolio return which will lead to a lower liability and an artificial higher available capital on the balance sheet. It creates an unintended incentive for companies to increase the risk profile of their investment strategy in order to evade large solvency capital.

Another crucial component of solvency capital and risk management is to identify and assess the operational risks insurance companies come to bear. Operational risks include internal and external fraud, employment practices and workplace safety, improper selling and lending, money laundering, questionable business practices, physical asset damage, system failures, and other disruptions in the business processes. Solvency II made explicit provisions and capital requirements to cover operational risk, while the North American regulators still remain on the fence. Although there has been a consensus among the regulators and industry that operational risks often lead to catastrophic losses, regulators outside the eurozone have failed to include operational risk component in their solvency capital requirements.

The Way Ahead

The European Solvency II directives are still in the process of being finalized. Given the vast complexity of asset and liability valuations and quantifications of various categories of risks in the solvency capital, it is not surprising that Solvency II is not without issues. For instance, it does not include the kind of excessive premium growth that US solvency capital formula incorporates and therefore does not discourage aggressive increase of policy sales. It also includes a smaller number of business categories, perhaps failing to reflect the heterogeneous nature of the insurance market as well as the US classifications. It also suffered a setback in its efforts to recognize company-specific experiences in the standard formula due to concerns over whether companies would be able to obtain data of sufficient and credible quality. However, the European regulators are likely to push forward with the incorporation of company experiences eventually; in the meantime, firms using internal models will be able to take into account their unique experiences. Nevertheless, Solvency II is a major step towards a more risk-sensitive, transparent, more objective, and market-consistent regulatory framework.

Outside Europe, national regulators have in recent years started to realize their disadvantaged position, and have signalled a move towards a direction similar to Solvency II. For instance, the US and Canada have made a commitment to gradually adopt the International Financial Reporting Standards (IFRS) which is more consistent with the Solvency II valuation principles. This highlights the importance of understanding the European approach, as the Solvency II balance sheet can be used as a proxy to gauge the financial impact of the anticipated transition towards the IFRS balance sheet.

Moreover, national regulators need to be alert to the arbitrage opportunities presented by the differences among various regulatory schemes in the world as multi-national insurance companies may take advantage of the lower capital requirements based on certain regimes and deploy their global capital accordingly. This is yet another argument for a harmonized global insurance accounting and solvency standard which will minimize such arbitrage opportunities and better safeguard the interests of policyholders. International organizations like IAIS should step up to the plate and take on the role of steering this historical transition.

The good news is that there have been recent signs that IAIS is making a more significant move by working on a plan to deal with global “systemically important insurers”. Insiders have made public statements regarding a new assessment methodology and policy measures for insurance companies that are heavily involved in non-insurance business. Although history has taught us that regulator “turf wars” and industry push-backs are part of the growing pains of any newly enacted regulatory framework, especially one with the ambition of being adopted by worldwide insurers, we have reason to hope that the world is ready for a more collaborated regulation approach in the wake of the global financial crisis.